The Mixture of Debt and Equity in a Firm - Term Paper Example

?Running Head: Finance Finance [Institute’s Does the mixture of debt and equity in a firm’s financial structure matter? Why?  A specific mix of capital structure incorporating debt and equity is essential to undergo various businesses and finance operation. The financial mix is a crucial structure that affects the risk and brand value of the business. It also relates to whether a possible mix of debt and equity can be used in order to opt for a least expensive source and finance the day-to-day activities (Narayanan, 2009). The debt financing includes bonds, leasing, borrowings from bank and mortgages and is universally seen as the easiest and cheapest way of financing activities. It also carries a tax-deductible benefit that is an attractive source in investing activities as interest payments will be expensed out (Narayanan, 2009). It also carried a risk of debt payments and leverage which could result in decrease in revenues. The probability of risk is also dependent on the industry it operates and the possibility of the firm to cover its fixed cost over profits. In the event of recession and inflation, the debt can have an adverse effect on the business activities as fixed cost directly affects the decline in sales that can also results in lower profitability (Cox, 2011). The equity finance is an expensive and exclusive method for raising capital in the business and it comprises of ordinary and preference shareholdings, bonds and floating market shares. It also includes a listing cost and legal paper work, potential shareholders and raises wider opportunity for pool of finance (Slee, 2011). The difference in usage of appropriate financial capital structure is the selection of Leverage the business can be adhered to. It signifies the impact of debt in the company’s capital structure e.g. long-term bonds for 5 to 8 years and their impact on company’s profitability and earning stream (Khan et al., 2005). If the debt ratio is higher in good economic terms than it will also improve the required rate of return and return on equity of the business, similarly, if the debt ratio is higher in terms of recession than it creates a significance risk to the business operations and its sustainable future (Slee, 2011). According to the conventional theory of Modigliani and Miller (1985), in a perfect world the mix of debt and equity does not matter when economic terms and corporate taxes are assumed to be constant. It also suggested that value of the firm is independent of the financial capital structures and overall operating cost (Cox, 2011). It further argued that if the benefit is obtained due to low cost debt then it could be offset against the cost of equity borrowing that will be considerably higher than the debt finance. It also suggested that the cost of capital remains the same irrespective of the appropriate mix between debt and equity. It can be argued that value of the business and cost of capital will remain constant in a tax-free world e.g. United Arab Emirates (Slee, 2011). Debt financing is bind by obligations to pay interest and principal amounts and failure to meet the payment may result in serious risk to the business and in further case negative impact on the value of firm such as Bankruptcy (Khan et al., 2005). It can also be argued that as compared to the conventional theory if the business’s debt structure is higher than the equity portion, it might result in increased risk of higher interest payments and probable bankruptcy as well. It will also increase the cost of capital for the bondholders thus also indicating a highly geared business. It is suggested that to create an optimal mix of debt and equity structure, the margin level of gearing should be equal or does not outweigh the probability of bankruptcy cost to the business (Ross et al., 2004). There are various debts to equity and debt ratio for industries and their risk level incorporating their business. The volatile industries like steel, cement, energy might adhere to higher debt ratio as compared to consumer goods and services industry (Khan et al., 2005). The changes in the effect of leverage of the industry also have a significant impact on the overall value of the business (Khan et al., 2005). The selection of appropriate mix of the financing structure also depends upon the attitude of the management. The risk averse or risk taker management influences the decision making of optimizing for the best mix of the capital structure. They set a certain threshold in optimization of equity and finance mix for instance they would evaluate the difference between the cost of debt and cost of equity on the assets of the business (Khan et al., 2005). If the secured borrowing is on mortgaging company’s business assets and premises than it is a risk taking approach with high indication of debt mix in the financial structure whereas if the financing is solely through or higher with equity finance or raising right issues that indicates a lower level of business risk in the operational activities. The advantage of using higher debt finance in the capital structure will enable users to utilize maximum resources in a much profitable way and the future payments of debt can also decline if the value of currency in exchange appreciate against the inflated one (Brealey, 2007). A strategy developed by different companies and countries contrary with the specific debt and equity mix of the companies. For instance in United Kingdom, a ratio of 1:2 shall be managed in order to maintain appropriate debt ratio to the equity ratio over the total assets of the company. As a rule of thumb, financing 50: 50 by debt to equity can be a preferred choice for optimization of the capital structure. The long-term debt must be limited to the percentage of equity funds (Ross et al., 2004). The mixture of both debt and equity has a strong impact on the leverage of the business, performance and cost of capital. The shareholders demands higher cost of capital when there is excessive or higher mix of debt finance in the capital structure as it indicates additional risk to the company’s assets. The maturation of debt also has a significant impact on the financial capital mix and performance of the business operations (Khan et al., 2005). The higher debt mix can be favourable in terms of growth opportunities for the shareholders, as they would accept business proposal or projects to accrue debt against the risk of non-payment by healthier profit margins. The attractive source and least expensive mean of debt financing is a possible choice for investing operations but higher mix in the capital structure might also affect the overall business performance as it can be utilised to reduce the impact of over capitalization and give signally effect to the shareholders in terms of payment of dividends (Khan et al., 2005). For an optimal capital structure, the business should maximise the value of the operations, decrease the financial cost and cost of capital in order to avoid the financial distress and risk associated with higher debt in the financial structure (Narayanan, 2009). The capital mix is also dependent on the expected rate of return and the amount of investment in the business. Therefore, if the investment is higher than usage of debt finance might increase the rate of expected return on the contrary if the investment is lower than borrowing cost then equity is a preferable choice, as debt will decrease the rate of expected return. The approximation of appropriate debt to equity is also essential as usage of higher debt finance leads of interest payments weekly or monthly that will affect the cash stream of the business. If certain months, there is lower cash stream or uncertainty for the payment of interest a cushion of equity finance can be utilised for further secured payments (Cox, 2011). The choice of an optimal capital structure, a trade off can be determined for associated the tax benefits of usage of debt finance in the capital structure and reduction of cost of capital of the business. The equity financing provides flexibility to meet up the sufficient investment opportunities and expenditure of the business and during the financial slacks, an optimal level of equity financing can aid the business profitability or financial stability. It is also dependent on the amount of competition in the market, volatility of the industry, maturity of the long-term bonds, and perceived risk associated with the industry (Slee, 2011). Conclusion: To estimate an appropriate financial structure for the company, the size, growth of the industry, risk, profitability and market analysis is required that can signify an appropriate margin for the selection of equity and debt in the capital structure as it has an effect on the business value, performance and long term stability in the foreseeable future (Khan, 2004). It is also dependent on other multiple factors such as cyclical business with higher business risk are less likely to opt for higher debt financing. The higher debt mix in the capital ratio might cause strain on the cash flow and profitability of the company as well as higher cost of risk associated with bankruptcy (Khan et al., 2005). The mixture of debt and equity mix strongly affect the above discussed factors and practical implication surrounding the business. The optimal usage of debt financing has a significant impact on the return but carries a strong risk with the rate of return. If the proportion of debt increase than it is likely that the probability on equity investment becomes more risky and increases the cost of financing equity shares and issues (Khan et al., 2005). If the cost of capital is unchanged with the increased cost of equity capital than the overall impact is nullified as long as the company is able to meet the payments and dividends for its shareholders. The exact proportion of the debt and equity mix cannot be measured or optimized as it varies on various factors but if it affects the cost of capital and the risk associated with bankruptcy then it will have a huge impact on the overall financial structure of the company (Khan, 2004). References Brealey, A. R. 2007. Principles of Corporate Finance. Tata McGraw- Hill Education Cox, W. D. 2007. Frontiers of Risk Management: Key Issues and Solutions. Euro money Books. Khan, Y.M. 2004. Financial Management: Text, Problems and Cases. Second Edition. Tata McGraw-Hill Education. Khan, Y.M. Khan & Jain, Jain, K.P. 2005. Basic Financial Management. Tata McGraw-Hill Education. Narayanan. P. M. 2009. ‘Debt versus Equity under Asymmetric Information’. Journal of Financial and Quantitative Analysis. Vol. 23, No. 1. Retrieved on March 11, 2013: http://journals.cambridge.org/action/displayAbstract;jsessionid=35BE041112D490D2F8CB97293A35EE5D.journals?fromPage=online&aid=4490108 Ross, A. S., Westerfield, R., and Jordan, D. B. 2004. Essentials of Corporate Finance. University of California: McGraw Hill. Slee, T. R. 2011. Private Capital Markets: Valuation, Capitalization, and Transfer of Private Business Interest. John Wiley & Sons. Read More